Fooled by Manager Returns

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In nearly every profession, past performance is indicative of future results. When picking a doctor, contractor, professor, attorney or professional athlete, naturally the key criterion to consider is their historical track record. The expertise of skilled professionals should be evidenced with consistent outperformance versus peers. Furthermore, the logic follows that anyone can suffer through a short-term setback for a variety of reasons, but the elite performers should not be expected to struggle for an extended period.

The same reasoning unfortunately does not apply to selecting investment managers. In fact, the counterintuitive nature of successful investing often requires acting against entrenched emotional biases that are shaped by the normal life experiences described above. We will describe why the conventional, instinctive approach to making investment manager choices generally leads to poor outcomes and how investors can be fooled by manager returns.

The traditional approach

If you were to ask a professional consultant or investor how they select investment managers, they would likely walk you through a well-rounded approach that combines “hard” data (strong historical performance) with “soft” analysis (qualitative evidence of superior skill). In practice, however, the manager’s returns tend to dominate the hire/fire decisions while less objective qualitative inputs often yield to the appeal of recent, precise data points. These are often reinforced by managers, most of whom are self-marketing experts, who ably weave compelling (and usually unprovable) stories to rationalize their recent success and why it should continue.

While all performance is usually considered, the convention is to focus on returns during the previous five years. Investors tend to assume that managers who have outperformed over a period as long as five years must be highly skilled and vice versa. It can be emotionally validating to hire a manager whose strategy “has been working” in the current environment. This further reinforces a short-term hard data approach to manager research. As just one example, Morningstar’s widely followed star rating also heavily weights historical five-year performance.1

The emphasis on short-term performance is heightened after the manager is hired and decisions are made about whether to retain or terminate the strategy. The return comparison to a relevant benchmark and peer group rankings typically dominate the evaluations of the manager’s success. This is in part due to a behavioral bias, to attach more value to information that is simple, immediate and precise. Whereas qualitative inputs can be ambiguous and more difficult to evaluate. When monitoring results this closely, five years may feel like an eternity. Very few investors exercise sufficient patience to hold on to an underperforming manager for several years, let alone five.